Towards a free trade nation (2)

This the second of two articles based on an excerpt from a paper by Ali Wardhana presented at the seminar of Indonesia and the World at the Beginning of the 21st Century jointly organized by The Jakarta Post and the Center for Strategic and International Studies on Oct. 17 in Jakarta in connection with the 50th anniversary of Indonesia's independence.

JAKARTA (JP): The government must do more than join and shape international agreements if we are to take full advantage of the global economy. I stated earlier that comparative advantage is not a static concept. As our abundant labor and natural resources are absorbed into industry and modern services, we will find that the cost of these resources climbs as our incomes rise. We will have to move on to more skill-intensive and more technology- intensive industries. The role of government in preparing for this transition is one of the burning policy questions that we face.

There are those who would have us "pick winners". This is the strategy attributed to Korea and Japan. In fact, the importance of picking winners in Korea and Japan is hotly debated by development specialists. There is no consensus on the extent to which these policies contributed to the rapid growth of those countries. But in a number of ways the debate is a moot one. The globalization of the world's economy and the emergence of widely agreed-to-rules on acceptable practices toward trade and investment mean that the policies attributed to Korea and Japan can no longer be followed.

The industrial policies of those countries revolved around a set of controls that enabled a government to allocate credit and foreign exchange to firms in the chosen sectors which conformed to the government's will. Further, those firms were protected at home from competition from imports and from local production by foreign investors. Unlike most inward-looking Latin American countries, however, the governments of Korea and Japan demanded efficiency of the favored firms. They had to face the rigors of export competition, or they did not receive credit or foreign exchange, or, in some cases, even further protection from foreign competition. The tools required to implement such a policy are complex. More important, they are no longer tolerated in today's integrated world.

Our commitment today must be to the private sector, with a role for government only where the private sector cannot be expected to undertake tasks. There are two tasks that the government must perform to ease the transition to the industries of the future: the provision of broader and better education and easing the way for private firms to develop technology and to acquire it from abroad.

The most significant obstacle to technology transfer is the capacity of developing economies to absorb and adapt technology. This capacity depends primarily on the human resource capacity of each economy. In recognition of the importance of science and technology to our development, Indonesia has made human resource development a top priority during our second 25 year development program. This priority manifests itself both in our commitment to nationwide junior secondary education and in our commitment to increase the quantity and quality of tertiary graduates. This includes greatly increasing the number of natural science and engineering students in higher education.

One of the key lessons to be learned from other countries' experiences is that technology development must be market- oriented and serve the needs of the private sector. Research conducted within government institutions and state enterprises can be divorced from the needs of modern business and industry.

This is a particular problem for Indonesia, where roughly 80 percent of research and development is both funded and performed by the government or in state-owned industries, and over 75 percent of natural scientists and engineers are employed by the government. The most urgent step currently needed is to increase the efficiency of technology diffusion by getting research and development out of government labs and state enterprises and into the private sector, where it would be directly relevant to industry. To support this process, the government is encouraging private firms to devote greater resources to research and development.

As we strive to raise the level of technology in Indonesian industry, we must be careful not to adopt policies that weaken our existing industries. In this regard I agree with Professor Sumitro's observation on the need to find the correct balance between "comparative" advantage and "competitive" advantage, while at the same time preparing ourselves for the future when we must move up the technology ladder.

We cannot prematurely reject natural resource-intensive and labor-intensive industries as we lay the groundwork for the skill and capital-intensive industries of the future. We must continue to support these industries for two reasons. First, they are a vital source of foreign exchange, accounting for almost one-half of non-oil exports, but on the other hand contributing very little to our net foreign exchange earnings and unlikely to do so for some time to come.

In light of the recent increase in our current account deficit, it would be unwise to abandon the industries that have become a mainstay of our economy over the past decade. Second, high-technology industries employ primarily skilled workers, such as technicians, engineers and natural scientists. However, two- thirds of Indonesia's labor force has no more than a primary school education. If we push aside labor-intensive industries to devote resources to high-tech industries, where will these 60 million-odd workers find jobs? Let us continue to support industries in which we are currently competitive, while investing in human resource development that holds the promise for Indonesia's future.

The dilemmas of managing the domestic economy in a world where borders are open to the easy flow of goods and money have long been clear from economic theory. The theory said that with highly mobile international capital, if we chose to maintain stability in the exchange rate, then our ability to use macro economic policies to stabilize the economy would be limited. On the other hand, if we insist on ease in managing the domestic economy, then we would have to accept greater instability in the exchange rate. Managing stability in both simultaneously would be extremely difficult.

In practice, until recently the constraints were more a theoretical matter than a real dilemma. When the economy became overheated in 1991, for example, we were able to apply monetary brakes without a serious challenge to the exchange rate policy. As many of you will remember, rather straightforward and simple policies that raised interest rates were effective in slowing the economy.

The world has, however, changed very rapidly. Global capital movements are now somewhere in the order of 70 times the value of world trade in goods. This integration of world capital markets has caused the theoretical problem to become a real problem. Today, if we raise interest rates significantly above international rates plus some risk premium, we are likely to face massive inflows of capital. These incoming funds would push the exchange rate up, requiring the central bank to purchase foreign exchange with rupiah and thereby increase money supply. But these increases in money supply would run counter to the original goal of slowing down the economy.

Some academics would say that there is a simple solution to the problem. Ignore the exchange rate: just let it seek its own level and concentrate on the domestic economy. In the short run exports would be hurt by the higher valued rupiah, but eventually the exchange rate would return to a rate that allows exports. Or domestic prices would be held in check until exports were once again competitive. This is, of course, a purely academic solution.

There are those who would say that a country could resolve this dilemma by imposing controls on the flows of capital, that in this way a country could have stability in its exchange rates as well as control over the domestic economy by limiting the cross-border flows of capital. This sounds deceptively simple.

Before I address those who would support capital controls, let me say that Indonesia has followed a policy of open capital account for some 25 years, and we have no intention of abandoning policies that allow investors to repatriate their profits and capital without restriction. This policy has served us well, and will continue to do so.

Are we then on the horns of a dilemma, with no effective policy tools? I am convinced that the answer is no. But I do believe that we need to draw on a more complex set of management tools and may even need to somewhat revise the incentives under which some of our institutions operate.

First, the inflows of foreign capital that accompany higher interest rates need not increase the money supply and thus generate impacts opposite to those intended. Thus far, there is no evidence that the inflows accompanying tightened monetary policy are greater than those that can be sterilized by the conventional tools of selling Bank Indonesia's deposit certificates and issuing less money market securities. Bank Indonesia has generally been very effective in these policies, even create difficulties for sterilization efforts.

Second, we have not exhausted other tools for managing the economy. We have more options than simply driving up interest rates through the sale of Bank Indonesia's deposit certificates or the manipulation of money market securities. We have, for example, not varied the reserve requirements of our bank, as other countries do. Radical changes could certainly threaten the solvency of some banks, but small changes may act as an effective tool for managing the domestic economy.

Third, fiscal policy remains an effective tool for managing the economy. Slowdowns in government spending, for example, or acceleration of tax collection serve to slow the economy. If inflation and current account imbalances become a serious concern, Indonesia could strive for an overall fiscal surplus along the lines achieved by other fast-growing, low inflation economies as Thailand and Malaysia. Some neighboring countries have also relied quite heavily on a variant of fiscal policy as they have timed releases from their "provident" funds to counter business cycles.

Fourth, Indonesia can support the efforts of international agencies such as the World Bank and the International Monetary Fund to seek new institutional means for responding to crises that disrupt world financial markets. The Mexican crisis of less than a year ago drew the world's attention to the serious disturbances that can result from the integration of capital markets and the ease with which money now flows across international borders. Large capital inflows can mask imbalances caused by poor macroeconomic management, and capital -- including domestic capital -- can bail out in a hurry when the imbalances become unsustainable.

Moreover, if investor confidence in one market is shaken, the ensuing ripple can threaten perfectly sound economies.

Dr. Ali Wardhana is a former economics minister and is one of the leading architects of the New Order economy.

Window A: As we strive to raise the level of technology in Indonesian industry, we must be careful not to adopt policies that weaken our existing industries.

Window B: We need to draw on a more complex set of management tools and may even need to somewhat revise the incentives under which some of our institutions operate.